Fitch Ratings says that a review of complex loans by U.S. banking regulators indicates that asset quality improvements have stalled, highlighting possible risks to lenders.
In a new report, the rating agency says that the latest review of complex loans held by multiple U.S. and foreign financial institutions — which is carried out annually by the U.S. Federal Reserve Board, the FDIC and the Office of the Comptroller of the Currency (OCC) to assess risk and underwriting standards relating to large, complex loans shared across the banking system, which total around US$3 trillion — “indicates that improvements in asset quality have stalled year-over-year and underwriting standards have diminished post-crisis, highlighting potential risks for both bank and nonbank lenders.”
It notes that the regulators reported that high-risk assets remain elevated at US$302 billion, representing 10% of total commitments. This is down just 60 basis points from 2012, following a 2.1% decline between 2011 and 2012. It also says that actual high-risk loan volume increased 2.4% year over year, and is now at about double pre-crisis levels, “highlighting the degree of asset risk remaining in the system four years after the start of the recovery.”
Fitch says that it believes that both the level of risky assets remaining in these portfolios, and the observed increase in riskier assets “is a concern, given the current fragile state of the U.S. economy, which has a substantial impact on the credit quality of these large loans.”
Indeed, it says that it sees the review’s results as “further evidence that competition among lenders is heightening risks in and outside the banking system.”
Additionally, Fitch says that it’s focused on the potential impact on loan quality, particularly in commercial and industrial (C&I) portfolios, once short-term rates begin to rise. It notes that, in the second quarter, the loss rate on C&I loans was just just 33 bps, compared with a long-term average of 93 bps. “We believe that recent C&I loan loss rates, which are below long-term historical averages, are unsustainable and have also been deflated given somewhat higher growth rates in lending activity over recent periods,” it says.
It also notes that the regulators’ report confirms its view that “underwriting, particularly in the C&I space, has weakened since the crisis given market liquidity and intense competition for loan growth.” Fitch says that the report points out that 34% of recently-originated leverage loans were cited for weak underwriting due to a combination of high leverage and an absence of covenants. “This will likely cause C&I loan loss rates to increase over coming quarters,” it warns.
Fitch says that it will continue to monitor this area and could take rating actions if observed loss rates increase outside of its expectations.